I’ve started Piketty’s new book, but just finished the first chapter (intro.) Here are a few initial observations:
1. He has a fairly left-wing worldview (albeit certainly not Marxist.)
2. He says that “all the historical data” shows that real wages in Britain did poorly in the first 1/2 to 2/3rds of the 19th century. I’m no expert here, but that’s not what I was taught. I was taught (at both Wisconsin and Chicago) that the data conflicted. Some data showed what Piketty claims, and some data suggested that real wages rose, that British workers did better than peasants, and also better than people on the continent. Does anyone know whether all the data supports Piketty’s claim?
3. He is rather dismissive of those he disagrees with. At Econlog I extensively discuss his mischaracterization of Simon Kuznets’ views. That’s the post to read if you are a visitor from MR and only have time for one.
4. He says the wealth/income ratio in the late 19th century was 600%, “which is a lot.” That doesn’t seem like a lot to me. It will be interesting to see if he later explains why it is a lot.
5. I’m not quite sure what motivated him to write the book. Is it a study of capital, of wealth, or of economic inequality? The title suggests capital, the intro suggests he’s more interested in wealth and income inequality.
6. He says that two key graphs motivate his study. One shows the U-shaped pattern in income inequality over time, and the other shows a U-shaped pattern in the ratio of private “capital” and income. The second graph has been challenged by Chris Giles. Then he gets to the model.
If, moreover, the rate of return on capital remains significantly above the growth rate for an extended period of time (which is more likely when the growth rate is low, though not automatic), then the risk of divergence in the distribution of wealth is very high.
This fundamental inequality, which I will write as r > g (where r stands for the average annual rate of return on capital, including profits, dividends, interest, rents, and other income from capital, expressed as a percentage of its total value, and g stands for the rate of growth of the economy, that is the annual increase in income or output), will play a crucial role in this book. In a sense, it sums up the overall logic of my conclusions.
I had read numerous reviews of the book, pro and con, before I started reading it, so I was well aware of the importance Piketty placed on the r > g relationship. When I first heard about this model it struck me as absurd. I started reading the book, thinking Piketty would provide some sort of persuasive explanation for the model. After all, the book is been very well reviewed, for the most part. And yet right after these two paragraphs, here’s what I found:
When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the nineteenth century and as is likely to be the case again in the twenty-first century), then it logically follows that inherited wealth grows faster than output and income.
This is even more absurd than I expected. It does not logically follow that inherited wealth grows faster than output and income. It just doesn’t. It’s wrong. I really don’t know what else to say, other than it’s wrong. At some level the Piketty probably understands his claim was incorrect, as he contradicts himself in the very next sentence:
People with inherited wealth need save only a portion of their income from capital to see the capital grow more quickly than the economy as a whole.
OK, so doesn’t logically follow, you need to make assumptions about savings. Does that help? Not really, because the model is still absurd. And that’s because the assumptions that you’d need to make about savings are utterly implausible. To see what’s wrong with Piketty’s model all you have to do is rewrite the “logically follows” sentence, replacing “inherited wealth” with specific families. Here is what Piketty claims is the “logical” model that lies at the very core of the book, rewritten by me:
When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the 19th century and as is likely to be the case again in the 21st century), then it logically follows that the wealth of the grandchildren of Bill Gates, Warren Buffet, Larry Ellison and all the other billionaires, will exceed their wealth. Indeed the wealth of the grandchildren will exceed their wealth by more that (1 + g) to the n power, where n is the number of years between now and when these billionaire’s grandchildren reach the same age. That’s about 60 years.
Using plausible growth rates, Piketty is saying that the grandchildren of these super-billionaires will “logically” be at least 4 times wealthier on average, or even more, even in real terms. He thinks that is the implication of r > g. Now to be fair, that may well be true in a few cases. But is that the expected result? Obviously not. Do you expect Bill Gates’ grandkids to eventually have $200 billion in 2014 dollars?
And the reason is obvious. Billionaires accumulate vast fortunes for a reason. They want to do something with the money. They want to do lots of things with their money. They have grand plans for a billionaire lifestyle. They have grand philanthropic interests. And yes, they also want to give some money to their children. Piketty continues:
Under such conditions, it is almost inevitable that inherited wealth will dominate wealth amassed from a lifetime’s labor by a wide margin, and the concentration of capital will attain extremely high levels–levels potentially incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies.
No it isn’t. What more can I say?
So why did Piketty make this mistake? Perhaps he was too influenced by European culture. In most European countries it is illegal for billionaires to give more than 1/2 of their fortunes to charity. So although Piketty’s model won’t even be true for Europe, it will be closer to the truth in Sweden than in the US. As an analogy, Keynes model was wrong, but most people think it was “less wrong” for depression-type periods with near zero rates, such as Keynes was familiar with in the 1930s, than for the economy at full employment.
How big of a problem is this? That depends. For the policy issues of interest to progressives, it may not be much of a problem at all. Even though Piketty’s model is wrong, his predictions may well be correct. Wealth may grow increasingly unequal. Perhaps wealth redistribution is needed.
However I do think it’s a big problem for Piketty’s book. If the book is a model plus data plus policy advocacy, then in my view he’s lost one third of the book in the opening chapter. In later posts I’ll let you know whether he collects the data that is most relevant to the issue of economic inequality, and whether he has good arguments for or against the standard remedy of a progressive consumption tax, with zero taxes on capital.
PS. After writing this I noticed a book edited by Joel Mokyr has a article by Deirdre McCloskey that claims British real incomes rose by two and a half times between 1780 and 1860, but that’s an average, and doesn’t account for changes in income distribution. Another article by Clark Nardinelli suggests that real incomes doubled between 1760 and 1860 and the share of income going to the bottom 65% fell from 29% to 25%. But even that suggest a substantial gain for average people. So I’m not sure that “all the historical data” shows what Piketty claims it shows.